Engineering Economics and

Finance
Unit 8
Consumer Behaviour Analysis
 Micro-Economics
• Branch of economics concerned with effects of decisions taken
by single or small groups of agents
• Topics to be covered:
o Consumer behavior analysis
• Study of how people make purchase decisions with regards to a
product or service
o Supply and demand analysis
• Study of how buyers and sellers interact to determine
transaction prices and quantities
o Decision making under risk and uncertainty
• Study of choices made by people when faced with incomplete
information and uncertain outcomes
 Consumer Behaviour Analysis

I. Utility Analysis
o Cardinal versus Ordinal Approach
o Law of Diminishing Marginal Utility

II. Consumer Behavior

o Indifference Curve Analysis
o Consumer Preference Ordering

III. Constraints
o The Budget Constraint
o Changes in Income
o Changes in Prices

IV. Consumer Equilibrium

UTILITY ANALYSIS
 Utility Analysis
• Utility: common denominator to measure
happiness

• Ordinal utility: ranking different things

o Watching sunset preferred to eating brownie

• Cardinal utility: assigning specific number

of utils to different things
o 25 utils to eating brownie vs 75 utils to
watching sunset
 Utility Analysis: Measures
• Total utility
o Utility derived from all units of product
consumed

• Marginal utility
o Utility derived from each additional unit
of product consumed
Total and Marginal Utilities
Marginal Utility Plots
Law of Diminishing Marginal Utility

All else equal, as consumption

increases the marginal
utility derived from each additional
unit declines
 Consumer Behavior
• Consumer: individual who purchases goods and services from
firms for purpose of consumption

• Key factors to consumer behavior:

o Consumer Opportunities: Goods and services consumer can afford to
consume
o Consumer Preferences: Goods and services consumers actually consume
 Indifference Curve

Good Y
• IC: Combinations of 2 or more
goods that give a consumer the
III
same level of satisfaction
II.
I
• Higher indifference curve .
indicates higher level of
satisfaction

• Shape of the curve determined

by consumer preferences
Good X
 Properties of Consumer
Preferences

• Completeness
• More is Better
• Diminishing Marginal Rate of
Substitution
• Transitivity
 Properties of Consumer Preferences: 1

1) Completeness: given any two bundles A and B, consumer is

capable of stating that he/she:
o Prefers bundle A to bundle B: A  B
o Prefers bundle B to bundle A: A  B
o Is indifferent between the two: A  B
 Complete Preferences

• Between bundles A, B, and C, Good Y

this consumer is III
o is indifferent between A and C .
II.
o will prefer B to A
I
o will prefer B to C . A
B

Good X
 Properties of Consumer
Preferences: 2
More is better: Bundles that have at Good Y
least as much of every good and more of
some good are preferred to other
bundles II.
oB  A since B contains at least as much I
of good Y and strictly more of good X .
A
oB  C since B contains at least as much 100 B

of good X and strictly more of good Y

oBundles on ICIII  bundles on ICII or ICI C
33.33
oBundles on ICII  bundles on ICI

1 3
Good X
 Properties of Consumer
Preferences
• Completeness
• More is Better
• Diminishing Marginal Rate of
Substitution
• Transitivity
 Marginal Rate of
Substitution
MRS: Rate at which consumer is Good Y
willing to substitute one good for
the other and still maintain the
same level of satisfaction
I
oConsumer is indifferent between .
A and C A
4
oTo move from A to C, consumer
gives up 2 units of Y and gains 1 C
unit of X 2

oMRS between X and Y is 2

oMRS = MUx / MUy 1 2
Good X
Properties of Consumer Preferences: 3

Diminishing Marginal Rate of Good Y

Substitution: As consumer
obtains more of X, amount of Y
he/she is willing to give up to
obtain another unit of X I
decreases
. A
100
•Units of Y given up to obtain
additional unit of X: 50
B

o From A to B: 50 33.33
C
D
o From B to C: 16.67 25
o From C to D: 8.33
1 2 3 4 Good X
•Gives IC a convex shape
 Properties of Consumer
Preferences: 4
• Transitivity: Consistent bundle of
Good Y
orderings
III
.
• For A, B, and C, transitivity implies II.
that if C  B and B  A, then C  I
A . A
100
C
75
• Transitive preferences along with B
50
the more-is-better property imply
that
o indifference curves will not intersect
o the consumer will not get caught in a
perpetual cycle of indecision 1 5 7 Good X
 The Budget
Constraint
• The Opportunity Set
Restricts consumer behavior by Y
forcing consumer to select an
‘affordable’ bundle Budget Line
• If M denotes income, P x denotes Y = M/PY – (PX/PY)X
M/PY
price of X and Py denotes price of Y
then budget constrain implies that
PxX + PyY  M.
• The bundles of goods that exhaust
a consumers income:
PxX + PyY = M M/PX
X
• The slope of the budget line
-Px / Py
 Changes in the Budget
Line
Y
• Changes in M1/PY

Income
o Increases in income leads to a M0/PY
parallel, outward shift in the
budget line
o Decrease in income leads to a M2/PY
parallel, inward shift in the
budget line

M2/PX M0/PX M1/PX

X
Y
New Budget Line for
M0/PY a price decrease.

• Changes in Price
o Decrease in the price of good X
rotates the budget line counter-
clockwise
o Increase in the price of good X
rotates the budgetline clockwise M0/PX M0/PX
X
(not shown)
0 1
 Consumer Equilibrium

Obtained at affordable bundle

Y
that yields highest level of
satisfaction Consumer
M/PY
Equilibrium

Indifference curve is tangential

to budget line

Occurs at point where: III

.
II.
MRS = PX / PY. I
. M/PX
X
 Slope of Indifference Curve

U = f (x, y)

Taking total differential, we get

dU=∂f/∂x.dx+∂f/∂y.dy

d U0 = 0

∂f/∂x.dx =-∂f/∂y.dy

(∂ f / ∂ x) / (∂ f / ∂ y) = - (d y / d x)

( MUx) / (MUy) = - (d y / d x)

d y / d x = - ( MUx) / (MUy)
 Slope of Budget Line

Y
change in
Slope = y
change in
0, M/PY
x
M/PY – 0
Slope of BL =
0 - M/PX

M/PY
Slope of BL =
- M/PX M/PX, 0
X
PX
Slope of BL = -
PY
 Consumer
Equilibrium
Occurs at point where:
Y
MRS = - PX / PY. Consumer
M/PY
Equilibrium

MRS = d x / d y = - ( MUx) /
(MUy)

III
- ( MUx) / (MUy) = - PX / PY .
II.
I
( MUx) / (MUy) = PX / PY . M/PX
X
 Numerical Example

Assume a consumer with utility function

U = U (X,Y) = (X+2)(Y+1)
and the budget constraint
M = 95, Px = 10 and Py = 5

a)Set up the constrained maximization problem, and derive the first-

order conditions
b)Find the amounts of goods X and Y the consumer will purchase in
equilibrium
Max U: xy +x + Substituting (3) in budget
2y + 2 constraint
s.t. 95==P10x+5y 95 = 10x + 5(2x+3)
MRS X / PY or ( MUx) / (MUy) =
95 = 10x + 10x + 15
P X / PY
MUx = du/dx = y+ 1 ------ (1) 20x = 80
MUy = du/dy = x+ 2 ------ (2) X=4

MRS = (y+1) / (x+2) = 10 / 5 Substituting x in (3)

y = 2*4 + 3 = 11

5y + 5 = 10x + (x*, y*) = (4, 11)

20
5y = 10x + 15
y = 2x + 3 ------ (3)